Speech
Opening Statement to House of Representatives Standing Committee on Financial Institutions
and Public Administration

I.J. MacfarlaneGovernor

Opening Statement to House of Representatives Standing Committee on Financial Institutions
and Public Administration8 May 1997

Thank you, Mr Chairman. It is a pleasure for me, and my colleagues, to be here this
morning.

This is the sixth time we have appeared before this Committee, but the first time
under the new arrangements agreed between the Treasurer and myself at the time
of my appointment, and contained in the document known as the Statement on
the Conduct of Monetary Policy.

That document was an important step in making clear the Reserve Bank's independence,
and we have always taken seriously the responsibilities that go with independence.
One important responsibility is to explain carefully and honestly to the public
and the Parliament what we are doing with monetary policy. That is why we had
no difficulty in agreeing to the proposals contained in the Statement on the
Conduct of Monetary Policy, including the two points that are relevant to today's
meeting:

that the Bank report on the conduct of monetary policy twice a year to this Committee;
and

that twice a year the Bank will release Statements on monetary policy and the role
it is playing in achieving the Bank's objectives.

We have decided to co-ordinate these two twice-yearly requirements so that the Statement
– which we have named the Semi-Annual Statement on Monetary Policy –
is available immediately prior to the meeting, and can form the basis for some
of the discussion.

The Bank now makes an increasing amount of information available to the public. Years
ago, the Annual Report was almost the only vehicle, but now it is supplemented
by a substantial flow of information in the form of press releases, articles
in the Bank's monthly Bulletin and speeches by senior officers. The additional
benefit that the Parliamentary hearings such as this can bring is that they
are a two-way process. Monetary policy inevitably contains an element of judgment,
which can differ between knowledgeable and well-intentioned people. This forum
allows members an opportunity to express different views and to pose awkward
questions, two activities I am sure you will engage in to the full. This is
a useful addition to the other checks and balances which are part of the democratic
process.

In my opening statement I would like to say a few words about the economy, monetary
policy and the financial markets. I would like to begin by giving you a brief
summary of our reading of the economy's current conjuncture and short-term
prospects.

As usual, the performance of the Australian economy is a mixture of some very good
aspects and some that are in need of improvement. Over 1996, GDP grew by around
3 per cent, with inflation about 2 per cent in underlying terms. This – the
fifth year of the current economic expansion – is a pretty good result
by the standards of developed countries: over that period, only two other OECD
countries out of 25 have done better on growth. However, 1996 represented slower
growth than in the previous few years and meant that the earlier decline in
the unemployment rate halted.

We believe in the period ahead that we will see an improved rate of economic growth,
which we see as something more like 4 per cent through 1997 than the 3 per
cent rates we saw over 1996. We believe 4 per cent growth should be quite sustainable.
At this stage, there is no reason why good rates of growth should not be achievable
over several years. Behind this view about a pick-up in growth are several
factors.

Consumer demand, which was weak during 1996, particularly the second half of the
year, is now looking stronger. No doubt, short-run figures will still contain
a good deal of variation, but the March quarter strength should be a pointer
to overall better growth in 1997. We should not, of course, be looking for
a boom in consumer demand – the need for improved savings remains great
– moderate growth would suffice.

To that we can add that an upswing in the residential construction cycle is in its
early stages, with a clear pick-up in lending, in local government approvals
and now in housing starts

Business investment should continue to be solid. The picture varies across industries,
but overall investment spending is likely to grow further, driven by quite
a strong increase in non-residential construction, and moderate growth in plant
and equipment. Unlike the late 1980s, moreover, the construction upswing is
broadly based, including in mining and infrastructure spending, not just concentrated
in office blocks. The overall financial climate should also underpin investment
plans, with share markets throughout the world, including Australia, at record
highs, and with bond yields and bank lending interest rates at or near their
lowest levels in this cycle.

The international environment is generally supportive of the Australian economy,
though as always there are things to watch. Growth is proceeding, and most
likely strengthening, in Japan and Europe, which have been weak for several
years. In the United States, the Federal Reserve has the job of slowing the
economy back to sustainable rates of expansion, without over-doing it. We all
have a big interest in them succeeding. In East Asia, growth is generally expected
to pick up; it is important that it does so, because this region has been the
major destination for Australian exports over recent years. This outlook is
moderated slightly by the fact that some countries in the forefront of this
expansion – such as the United States and the United Kingdom –
have reached the phase where monetary policy is being tightened.

Overall then, we see reasonable prospects for growth ahead, and we think that it
will be somewhat better growth than we experienced in 1996.

This should do something to help a lacklustre labour market. The labour force figures
have been particularly hard to get a clear signal from in the past several
months. Around the turn of the year, it appeared we were getting a good acceleration
in employment growth. The past couple of months, however, have seen that unwound.
We will get another reading today.

Whatever that may show, it is unwise to get too carried away by short-term trends.
What can be said with reasonable confidence is that employment growth has been
weak over the past year or more, but that leading indicators like vacancies
are signalling some strengthening in future employment conditions. We cannot
be sure how robust that will be, but some employment pick-up would be consistent
with the firmer growth picture we anticipate. This is the thrust of the analysis
in our Statement. As always, we will be evaluating all the relevant information
as best we can, continually updating our view on the economy and its prospects.

Inflation, meanwhile, has come down over recent quarters. Underlying inflation peaked
at 3.3 per cent, which is as you know higher than we could accept in the medium
term, but has now come down to a level of about 2 per cent on the latest figures.
It was this decline which made room for the three easings of monetary policy
which we put in place in the second half of last year. The decline owed something
to the slower economy, which increased competitive pressure in many markets,
constraining firms' ability to raise prices. This same factor helped to produce
some slowing in growth of labour costs. A third factor was that the Australian
dollar firmed during 1996, and this has pushed down prices for traded goods
and services.

In the next year or so we expect to see a continuation of this low inflation. Beyond
that horizon, as the recent exchange effects wear off, the on-going rate of
inflation in the domestic price and cost structure will reassert itself; at
present, the domestic part of inflation appears to be higher than the overall
underlying inflation rate. For example, private sector service prices are growing
at 2.5 per cent and domestically produced goods at 3.3 per cent. Containing
growth in labour costs is important to sustaining a combination of good inflation
outcomes in the domestic economy, and good growth in output and employment.
I will return to this theme shortly.

I would like to turn now to some aspects of the operation of the monetary policy
regime itself.

A central part of our framework is the inflation target, which, in essence, says
that inflation should average "two point something" per cent. We
think this target has helped to bring the community's inflation expectations
down, but there is still further to go. Lower inflationary expectations are
important in achieving a good combination of low actual inflation and sustainable
expansion in the real economy.

Low inflation, and our inflation targeting arrangement, also helps to build credibility
internationally for Australia's policy generally. This is not just pandering
to markets; it is worth having for genuine reasons. One is that long-term interest
rates for all borrowers – government and private alike – are lower
if we can convince lenders we are likely to keep inflation down.

Because we have an inflation target, some people think that it means we do not pay
attention to economic growth or employment. This is not true. To paraphrase
my predecessor – "We do – because our charter requires us
to but, more importantly, we do so because it is sensible to do so." In
thinking about how best to live up to this objective, however, a central bank
has to have a longer time perspective than some other observers may adopt.
It is long, durable expansions in the economy which offer the best prospects
for building a solid base of industry, jobs and prosperity. Our observation
of history, moreover, is that good growth and long expansions have always gone
hand-in-hand with low inflation. Weaker growth and short expansions have been
a feature of the high inflation era, particularly the 1970s, but also in some
parts of the 1980s.

We want, and need, a long expansion this time. We do not want the expansion to last
only six or seven years and be followed by a serious recession, as on the last
two occasions. The damage, particularly to unemployment, occurs during these
big recessions. The net rise in unemployment in Australia over the past 25
years has not been due to prolonged periods of weak economic growth; it has
been concentrated into three relatively short periods of recession. The best
thing we can do to improve our employment prospects is to prolong the expansion,
improving its durability by avoiding inflationary and other imbalances, thereby
delaying and reducing the severity of recessions which will inevitably occur
at some stage. Making this a long sustainable expansion is our main objective;
continuation of low inflation is a means toward that end.

While seeking to maintain that long-term perspective, we are continually monitoring
the information that comes in on the economy to see whether it is sending us
a message about the need to change policy. When we saw evidence of lower inflationary
pressures in the middle of last year, we took the opportunity to lower interest
rates on three occasions – July, October and December. I found myself
in the position of initiating monetary policy easings at two of the first three
monthly Board meetings I chaired.

I expect there will be a view that with inflation at the bottom of the 2-3 per cent
range, with the possibility that it might go a little lower, and with the economy
having grown more slowly during 1996 than its potential, many people would
be asking "why not keep easing?". Part of the answer is that the
full effects of the previous three easings are still coming through. We need
to keep this in mind.

One possible hurdle to lower interest rates was removed in the Australian Industrial
Relations Commission's decision in the Safety Net Review, which sought to carefully
balance concerns about the living standards of the low paid and the economic
sustainability of widespread and substantial rises in income for these people.
The decision was moderate, and increased the probability that aggregate wages
growth would be consistent with continued low inflation.

Other information received recently has been less reassuring. The various sources
of data on wages paint a picture which is far from straightforward to interpret.
One series on which we place a good deal of weight – though not exclusive
weight – is average ordinary-time earnings for adults working full-time.
This series has been influenced during much of the past year by some quite
improbable numbers for public sector wages, but even discounting it to some
extent for that effect, wages growth seems to be at levels which are too high,
and from the run of quarterly figures one can hardly conclude that the earlier
slowing in average wages growth has continued; if anything, the picture the
figures paint is of an acceleration. More information about aggregate wages
will be available soon, as will data on enterprise bargains. In the meantime,
the continuing substantial claims (and, in some cases, settlements) that are
contained in some current negotiations, including (but not confined to) the
metal industry, give us less than full confidence that the bargaining stream
is moderating appreciably. Overall, it is difficult to escape the conclusion
that wage bargains and average wage outcomes are somewhat higher than they
really should be in an economy characterised by low inflation and quite high
unemployment.

This conclusion also seems to emerge from international comparisons. As our Semi-Annual
Statement notes, most developed countries have inflation rates around 2 per
cent and rates of growth of earnings around 3 to 4 per cent. Australia stands
out as an exception where low inflation has not translated as fully as it should
have into lower wage growth.

Whether aggregate wages growth of 4 per cent and enterprise bargains of 5 plus are
bound to lead to higher inflation is a moot point. In some sectors, such as
manufacturing, they are probably not inflationary; the squeeze there seems
to be showing up as higher unemployment rather than higher inflation. Firms
may well accept 5 per cent wage increases, but manage to keep the increases
in their total wage costs much smaller than that by shedding staff. In other
sectors of the economy which are not so open to international competition,
such as transport, higher wages will probably be passed on to consumers as
higher prices.

I would like to be in Alan Greenspan's place where over the past 15 months he has
been regularly "surprised" by lower unemployment, and lower inflation
and wage growth than expected. In Australia, given the degree of slack in the
economy and the level of unemployment, I thought we might also have been surprised
by some lower than expected wage numbers. Overall, I am not sure we are in
that position; I fear we are still waiting to get that good news.

I now turn to financial markets.

As we note in the Statement, the exchange rate of the Australian dollar has moved
to a flatter trend over the past year after rising strongly in the second half
of 1995 and the first half of 1996. If anything, the exchange rate against
the US dollar has been a little lower so far in 1997 than it was in the second
half of 1996. The exchange rate has also been relatively steady against most
of Australia's other trading partners.

In trade-weighted terms, however, it has risen recently. At its present level of
60.2, it is about 3–4 per cent above its level a year ago. This rise has contributed
to the fall in inflation and has put some pressure on the internationally-traded
sector of the economy. Overall, however, the exchange rate remains within 5
per cent of its long-run average.

The trade-weighted index reflects a wide range of influences, but the main reason
for the rise in the index over the past year has been the extraordinary weakness
of the Japanese yen. It has fallen against all major currencies on world markets,
but its effect on the trade-weighted index of the Australian dollar is greater
than for other currencies because the yen has by far the biggest weight in
our TWI. In recent years, the yen has been very volatile (in 1995 it was the
strongest currency in the world), reflecting the difficulties experienced more
generally by the Japanese economy. There are hopeful signs that Japan is emerging
from that difficult period, which will in due course allow the authorities
there to return to a more normal setting of monetary policy. That would also
provide support for the yen, which, other things equal, would reverse some
of the recent upward pressure on Australia's trade-weighted exchange rate.

In terms of other financial market developments, we have seen marked falls in interest
rates over the past year, not only at the short end but also in the longer-term
rates set in capital markets. The yield on 10-year bonds, for example, has
fallen by over 100 basis points over the past year to 7.75 per cent. This reflects
the improvement in the Government's fiscal position and the fall in inflation,
rather than international influences. As such, our yields have fallen not only
in absolute terms, but also relative to those overseas. For example, a year
ago, our bond yields were 250 basis points above those in the United States;
today, they are only 100 points above.

The fall in bond yields also has important benefits for business and government,
not only in directly reducing their interest costs, but also by increasing
confidence in the share market and thereby allowing businesses easier access
to equity funds. Share prices in Australia are at record levels at present,
reflecting the favourable interest rate environment and generally high levels
of corporate profitability. Share markets in most other industrial countries
are also at very high levels, suggesting there is a fair amount of confidence
among investors about prospects for the world economy over the next year or
two.

Interest rates on offer through the banking system have also come down sharply over
the past year. This has been underpinned by the three easings of monetary policy
and, particularly in the case of housing loans, by a marked increase in competition.

Business loan rates have fallen by about 1.5 per cent since mid 1996, in line with
the reduction in cash rates brought about by the easings in monetary policy.
Rates at present are close to the lows reached in 1993/94. In the case of housing
loans, rates have fallen by 3 per cent over the year, to 7.5 per cent, the
lowest level in a generation. If we also take into account the absence of rationing
since deregulation of the financial system, housing finance is probably more
affordable and more accessible than at any previous time in Australia's history.

It is not surprising, therefore, that we are seeing a healthy demand for credit at
present. This, and our more general assessments about financial conditions,
leads us to the view that financial conditions are not impeding the expansion
in the economy at present.